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Financial Statements & Measurement of Financial Condition:

Public firms are required to produce financial statements including:

• The balance sheet

• The income statement
• The statement of cash flows
• The statement of changes in equity

We will look at the first two and include some information on cashflows.
Financial statement analysis involves the use of financial ratios to
analyse a company’s performance. We will look at standardly used
ratios. Be aware that different analysts may calculate some of these
standard ratios slightly differently. So take care when comparing data
from different sources.

The balance sheet

(Refer to Parrino Chap 3 section 3.2 for more information on the balance sheet)

The balance sheet reports the company’s financial position at a particular

point in time.
The balance sheet records information to allow us to measure the net
worth of the business, also known as the equity or shareholder’s funds.
The idea behind the balance sheet is the equation

Assets – Liabilities = Equity

The equity means the share of the value of the assets of the business
owned by the owners of the business. The rest of the assets are used to
repay the debt / liabilities of the business.
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Values used in the balance sheet: Book Value versus Market Value
The values of the assets and liabilities in the balance sheet are “book
values” and not “market values”
Book value
Usually means the original cost of the item, perhaps adjusted for
depreciation. Book value has the advantage that it is a figure which is
easily obtained / estimated and it has low variability. Usually the number
can be determined with certainty.
Market value
In the case of assets, this means how much you could sell the asset for to
some other party in an “arm’s length transaction” in circumstances where
the buyer is willing to buy but not under any pressure or obligation to do
so.
In the case of liabilities, the market value is the amount of money you
would have to pay someone else to take responsibility for the financial
obligations involved, both immediate and future obligations.
Sometimes it can be difficult to measure / estimate the market value of an
asset or a liability. For some assets there is an active market where the
asset is traded easily and frequently. In the case of shares traded on the
stock exchange, the market prices are observable every day.
In the case of debts owed by the firm (a liability), if the debt is a corporate
bond, which is a tradeable financial instrument, then it may have an
observable market price. The firm could decide to use its reserves of cash
to buy the corporate bond back from the investors who own it at its
market price. In this case the liability clearly has a market value.
However, in some countries, including Australia, corporate bonds are not
very actively traded and the market price is difficult to observe.
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In the case of other liabilities, such as bank loans (which are not
tradeable), the value is best estimated as the book value of the debt.

For some long term liabilities, such as pension fund payments, amortizing
mortgage loans etc the value of the liability can be estimated
mathematically.

But it can be a lot of work to do this, and the estimate may not be correct.
We need to make many financial assumptions to make the estimate.
Without an active market for the item being valued, the estimated market
value could be quite inaccurate.

We will be covering various methods for the estimation of the value of

assets and liabilities involving payments spread over future periods in
future lectures.

Even where an asset or a liability is a tradeable financial instrument with

an observable market price, these prices often vary a lot from one day to
another.

The purpose of the balance sheet and the income statement is supposed
to be to present a “true and fair” representation of the financial condition
of the firm. The use of book values means this is not necessarily the
case. However the use of market values produces a lot of variability in the
results and for some items it is very difficult to obtain the market values.

For these reasons and due to the widespread acceptance over time of
using book value, book values are usually used in financial statements.
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EXAMPLE BALANCE SHEET

Assets year year ITEM
t t-1
cash and cash equivalents 356 350 A
accounts receivable 1356 1480 B
inventory (at lesser of cost and market 2658 2470 C
value)
prepaid expenses 42 34 D
accumulated tax prepayment 70 58 E
current assets 4482 4392 F=A+B+C+D+E

fixed assets at cost 3192 3076 G

less accumulated depreciation 1714 1582 H
net fixed assets 1478 1494 I=G-H

investments (long term) 130 0 J

other assets (long term) 410 410 K
total assets 6500 6296 L = F+I+J+K

liabilities and shareholder's equity

bank loans and notes payable 896 712 M
accounts payable 296 272 N
accrued taxes 72 254 O
other accrued liabilities 382 328 P
current liabilities 1646 1566 Q=M+N+O+P

long term debt 1262 1254 R

ordinary share capital 1564 1564 S

retained earnings 2028 1912 T
total shareholder's equity 3592 3476 U= S+T

total liabilities and shareholders 6500 6296 V=Q+R+U=L

equity
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In the balance sheet the ASSETS are categorised as

• Current assets
• Fixed assets
• Long term assets

Current assets
This means

• assets that are either cash, or assets that are likely to be converted
into cash within 1 year. This includes short term deposits.
• money owed to the firm by customers who were allowed to buy now
and pay later (also known as “debtors” or as “accounts receivable”)
• inventory (which means either finished products ready for sale or
raw materials ready to be used in the production process)
• prepaid expenses (e.g. for insurance cover you usually pay the
premium for a year’s cover at the start of the year) for services paid
for up front but delivered over the next 1 year

fixed assets

• this means items such as machines, cars, computer equipment,

buildings etc
• these items tend to decline in value over time as machines
eventually wear out and need to be replaced
• these items are recorded in the balance sheet at their original cost
less the accumulated depreciation on the asset

long term assets

• this may include assets such as shares and bonds and other long
term investments, e.g. a share in the revenues from operating a toll
road.
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LIABILTIES
In the balance sheet the liabilities are categorised as
current liabilities - this includes

• bank loans and other loans payable during the next 1 year
• interest payments payable within the next 1 year due on long term
debt
• accounts payable (money the firm owes to suppliers of goods and
services received but not yet fully paid for), also known as “creditors”
• taxes payable during the next 1 year

long term debt – this includes

• various types of loans (e.g. bank loans)

• corporate bonds which are tradeable on the financial markets
• might also include long term finance leases

other long term liabilities – this could include

• worker’s compensation insurance payments to injured workers

• pension payments to senior staff who retired
• payments on long term contracts for supply of commodities /
services

The shareholder’s equity

This is usually included / packaged with the liabilities to make up a
category of “liabilities and shareholder’s equity”

The shareholders own the firm via the shares they hold, however the firm
has no obligation to “retire” the shares (pay the shareholders off and
buying / cancelling their shares), nor do they have any obligation to make
dividend payments or other payments to the shareholders out of the
profits of the firm.
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The shareholder’s equity is a “residual” or “difference” between the value

of the assets and the value of the liabilities. When using book value for
the measurement, the value of equity as per the balance sheet may be
totally different from the value of the shares in the open market.

Net working capital

The difference between current assets and current liabilities is the firm’s
working capital, the capital available in the short term to run the business.
WC = CA – CL.
Net working capital is a measure of a company’s liquidity, which is the
ability of the company to meet its obligations as they come due.
Almost all companies have more current assets than current liabilities, so
net working capital is positive for most companies.
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The income statement

(Parrino Chapter 3 Section 3.3)
This lists the firm’s revenues and expenses over a period of time. The last
or ‘bottom’ line of the income statement shows the firm’s net profit, which
is a measure of its profitability during the period.
The income statement is sometimes called a profit and loss, or ‘P&L’,
statement.
Note the net profit is also referred to as the firm’s earnings.
Sample income statement
YEAR YEAR ITEM NOTES
T T-1
NET SALES 7984 7442 A
LESS COST OF GOODS SOLD 5360 5000 B
GROSS PROFIT FROM
2624 2442 C C=A-B
TRADING

LESS EXPENSES:
SELLING, GENERAL AND
1824 1682 D
ADMIN EXPENSES
INTEREST 170 140 E
NET PROFIT BEFORE TAX 630 620 F F=C-D-E

LESS:
TAX EXPENSE 228 224 G
NET PROFIT AFTER TAX 402 396 H H=F-G
PLUS
OPENING RETAINED EARNINGS 1912 1776 I
TOTAL AVAILABLE FOR
2314 2172 J J=H+I
APPROPRIATION
LESS DIVIDENDS 286 260 K
CLOSING RETAINED EARNINGS 2028 1912 L L=J-K
INCREASE IN RETAINED
116 136 M M=L-I
EARNINGS
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the cost of goods sold means the cost of producing the products /
services that were sold during the reporting period. This typically includes
cost of raw materials, labour costs, manufacturing overhead
selling general and admin expenses are shown separately from the
cost of goods sold – these are costs incurred every period independently
of the cost of goods sold (c.o.g.s.).
interest expense is also shown as a separate expense item
depreciation expense
• may be shown separately or may be included in the figure for c.o.g.s.
• if included in c.o.g.s. then the gross profit is calculated after
depreciation is counted as an expense
• if shown separately it will probably be excluded from the calculation of
the gross profit from trading, however it will then be included (as an
expense) in determining the net profit before tax from the gross profit
before tax

The net profit before tax is also called the taxable income.
Tax is payable on this item.
The net profit after tax (NPAT) is the after tax earnings of the firm, also
called the EARNINGS (or Net Income)

The retained earnings of the firm from previous years, combined with the
NPAT from this year gives us the amount of money available to the
management of the firm for “appropriation”. This money can either be

• invested in new projects / assets for the firm

• held as a cash balance in a bank account
• paid out to the shareholders in dividends

The management can decide this, regardless of what the shareholders

want.
The amount available for appropriation less the dividends paid is the
closing (end of year) retained earnings.
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EBIT = EARNINGS BEFORE INTEREST AND TAX

This is a measure of the firm’s earnings before tax ignoring how the
financing of the firm with debt and equity is organised.
For our sample income statement we have
EBIT = Net profit before tax + Interest = 630+170 = 800

Cashflow
(Parrino 3.5 p72 and p73)
The term cashflow has different meanings depending on the context.
In project evaluation, it means the amount and timing of payments.
In accounting, it means actual cash receipts or payments instead of
“profit” or “earnings”. Accounting Cashflow is a simple concept but it
should not be confused with "accounting profit" or "earnings" or
"income". Cashflow is the actual money paid out or received at various
points in time. Net cashflow is the cash that a company generates in a
given period (cash receipts less cash payments)
Profit ≠ Cashflow
Profit is equal to revenue minus expenses. Profit as per the firm's
published financial statements (Income or Profit and Loss statement)
does not necessarily coincide with cashflow
Some of the items included in the accounting income statement for a
period may have a cashflow effect in a different period: either in the
future or in the past e.g. a sale or a purchase on credit will be included in
the accounting income statement but the actual cash payment may not
occur until months later.
Some expenses built in to accounting earnings are not actual cashflows:
e.g. depreciation is an expense but not a cashflow as such. It may be
that depreciation is calculated differently for accounting reporting
purposes than it is for tax purposes.
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Utilising and analysing the information in the financial statements

Various metrics / measures / ratios can be computed from the Balance

sheet and income statements
These can be compared over time within the company to examine trends.
These can be compared across companies within the same industry / line
of business.
We will look at financial ratios that measure a company’s liquidity,
leverage, profitability and market value.
Parrino Chapter 4 section 4.3 covers financial ratios (Efficiency ratios are
shown in the appendix and are not examinable).
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Short Term Liquidity Ratios:

Current ratio
This is the ratio of current assets to current liabilities.
current assets
This is defined as current ratio =
current liabilities
This is a measure of a firm’s ability to pay for its current liabilities, i.e. to
meet its short term financial obligations from its short term assets. This is
a measure of the firm’s short term liquidity. For the balance sheet above
this ratio is
4482
current ratio =  2.722965
1646

Quick ratio (‘acid-test’ ratio)

This is the ratio of current assets excluding inventory to current liabilities.
current assets - inventory
quick ratio =
current liabilities
This is also a measure of liquidity for the firm, but a more conservative
measure.
4482 - 2658
quick ratio =  1.108141
1646

Ideally we would like both of these ratios to be higher than1.00

A ratio below 1.00 is not a good sign
Sometimes the inventory cannot be quickly converted into cash
(particularly the raw materials). This is the reason for excluding it from
current assets in the quick ratio measure.
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Leverage ratios
The term financial leverage refers to the use of debt in a company’s
capital structure. Leverage ratios measure the extent to which a
company uses debt rather than equity financing and indicate the
company’s ability to meet its long-term financial obligations, such as
interest payments on debt and lease payments. The ratios are also
called long-term solvency ratios.

The debt-equity ratio

The debt-to-equity ratio tells us the amount of debt for each dollar of
equity.
This ratio is often used to assess a firm’s leverage.
book value of debt (incl CL)
This is defined as debt to equity =
book value of equity

market value of debt

Or sometimes defined as debt to equity =
market value of equity

This alternative definition will of course produce a different result. The MV

of equity is usually very different from the BV of equity. The MV of debt
may in sometimes be difficult to observe, as corporate debt is sometimes
not actively traded in the market.

For the above balance sheet we have

book value of debt 1646  1262
debt to equity = =  0.809577
book value of equity 3592

Creditors are providing $0.81 of finance for each $1.00 of finance

provided by equity holders
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The debt-to assets ratio

(also known as the debt ratio or total debt ratio)
This is another ratio often used to assess a firm’s leverage. This is
book value of debt d
debt to assets = 
book value of debt+book value of equity d  e

This can be calculated using either book values or market values.

For the above balance sheet this is

d 1646  1262 
debt to assets =   0.447385
d  e 1646  1262   3592

This ratio gives information about the relative weighting of debt in the
firm’s capital structure. The higher the ratio, the more debt the company
has in its capital structure.

Equity Multiplier
The equity multiplier tells us the amount of assets that the company has
for every dollar of equity
total assets
Equity multiplier =
total equity

For the above balance sheet we have

6500
Equity multiplier =  1.809577
3592
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Note:
All the above three leverage ratio are related by the balance sheet identity
(Total assets = Total liabilities + Total shareholders’ equity).
Once you know one of the three ratios, you can calculate the other two
ratios. All three ratios provide the same information.
Relationship between the equity multiplier and the Debt-to-equity ratio
Equity Multiplier = 1+ Debt-to-equity ratio

Relationship between debt to equity and debt ratio:

Debt ratio in terms of debt to equity ratio:
d d e debt to equity
Debt ratio =  
d  e d e  1 debt to equity  1

Debt to equity ratio in terms of debt ratio:

d    d  d  e    d  d  e  
 
debt ratio
Debt to equity = 
 e  (e  d  d )  d  e   1  d  d  e   1  debt ratio

Both the d/e ratio and the d/(d+e) ratio can be used to measure the level
of debt in the firm, which in turn partially reflects the riskiness of the firm
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The long term debt to long term finance ratio

This is another ratio often used to assess a firm’s leverage.

This is defined as
long term debt 1262
LTD/LTF =   0.259992
book value of equity+long term debt 3592  1262

This gives information about the relative weighting of long term debt in the
long term financing of the firm

Coverage Ratios

INTEREST COVER RATIO

(also called Times interest earned)
This is defined as
EBIT
interest cover =
INTEREST EXPENSE

This measures the ability of the firm to meet its interest payment
obligations on its debt, from the EBIT. The ratio should definitely be
above 1.0 for the firm to be financially healthy.
800
For our firm, we have interest cover =  4.705882
170
This means the firm has plenty of capacity to meet its interest payment
obligations.
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Profitability Ratios
Profitability ratios measure the management’s ability to efficiently use the
company’s assets to generate sales and manage the company’s
operations. In general, the higher the profitability ratios, the better the
company is performing.

Gross profit margin:

gross profit sales - cost of goods sold
gross profit margin = 
sales sales
2624
For our data we have gross profit margin =  0.328657  33%
7984

net profit after tax

Net profit margin: net profit margin =
sales
402
For our data we have net profit margin =  0.050351  5.0%
7984

total earnings
return on equity (ROE) =
total book value of equity

This is another profitability measure, it measures the return earned

by the shareholders on their investment in the firm. The possible
flaw in this measure is it is based on bv of equity instead of mv of
402
equity. For our data ROE =  0.111915  11.2%
3592
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net profit after tax

return on assets (ROA) =
total assets
This is another profitability measure, it measures the overall return
earned by the firm from the assets it controls. The possible flaw in
this measure is it is based on bv of assets instead of mv
402
For our data ROA =  0.061846  6.2%
6500
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DuPont analysis for ROE

Split the ROE into components based on the following expression.

 total earnings   total sales   total assets 

ROE   
  
  
 total sales   total assets   book value of equity 

This allows comparisons across firms and allows us to analyse the

reasons for variation in ROE. The components of this measure are:

 total earnings 
 
 total sales 
This is a measure of profit margin – how much profit in each sale?

 total sales 
 
 total assets 
This is a measure of asset turnover, how fast shareholder’s assets
are converted into sales

 total assets  DE D

    1 
 book value of equity  E E

this is another measure of the leverage in the firm, also known as

the equity multiplier
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Market Valuation ratios

Financial analysts have developed a number of ratios, called market
value ratios, which combine market-value data with data from a
company’s financial statements.
The most common used market-value ratios are:
Earnings per share, the price earnings ratio and market-to book ratio.

Earnings per share (EPS)

total earnings
earnings per share (EPS) =
number of shares on issue
This, combined with the PE ratio, is one way of estimating the value of a
firm’s shares – more on this later
total dividends
dividends per share (DPS) =
number of shares on issue
This, combined with the Gordon growth model (covered later), is another
way of estimating the value of a firm’s shares – more on this later

The price-earnings ratio (P/E).

 total market value of equity  market price per share

PE ratio =  
 total earnings of the firm  earnings per share

The PE ratio is one way of measuring the value of a firm by looking at

how the price is related to the earnings. Some firms have a high ratio of
share price to earnings per share, some have a lower ratio.

The product of the PE ratio and the firm’s earnings per share is the share
price. If we can estimate the PE ratio from the prices of other shares in
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similar firms and we can also estimate the eps of our firm, then we can
make an estimate of the market price of our firm.

Market to book value ratio

The market value to book value ratio is another “market valuation
ratio”, used in a similar way to the PE ratio.
MV/BV: This is the ratio of a firm’s market capitalisation to the book value
of shareholders’ equity,

 total market value of equity  market price per share

MV/BV Ratio =  
 total book value of equity  book value of equity per share

The market capitalisation means the number of shares on issue multiplied

by the market price per share. This is an estimate of what it would cost to
buy all of the shares on the open market.

This MV/BV is sometimes used for the purpose of estimating the value of
a firm, based on the ratio observed for other firms and the bv of equity of
this firm.

Summary of Financial Ratios from Parrino 4.3
Short term Liquidity ratios
Efficiency ratios
Leverage ratios
Profitability ratios
Market Value ratios
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Current ratio
Quick ratio
Inventory turnover ratio
Inventory turnover in days
Receivables turnover
Receivables turnover in days
Assets Turnover
Debt to equity ratio
Equity Multiplier
Interest Cover ratio
Gross Profit Margin
Net Profit Margin
Return on Assets
Return on Equity
Price Earnings ratio
Market-to-book value ratio
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Appendix: Efficiency ratios (non examinable)

Receivables Turnover (RT) ratio

annual net credit sales
Defined as RT 
accounts receivable
For instance, based on our Balance Sheet and Income statements and
the assumption that all sales in year T are credit sales we have
7984
RT   5.887906  5.9 times per year
1356
The average time in days for this interval is
365
receivables turnover in days (RT D) 
RT
365
For our data RTD   61.99148  62 days
5.887906
This measures how long is the time interval between when a sale is made
and when the cash for the sale is collected.

Payables Turnover (PT) ratio

annual net credit purchases
Defined as PT 
accounts payable

The average time in days for this interval is

365
payables turnover in days (PTD) 
PT
The income statement and balance sheet don’t provide the information
we need for the numerator of this ratio. This would have to obtained from
the accounts department / management accounts instead. This average
time in days to pay for our credit purchases can be compared to the
average collection period. It can also be compared with that of other
firms.
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Inventory Turnover (IT) ratio

cost of goods sold
Defined as IT 
inventory

In computing this ratio the denominator may be the average of the

opening and closing inventory instead of just the inventory figure at the
end of the year.
The average time in days for this interval is
365
inventory turnover in days (IT D)  days
IT
5360
For our data, IT   2.016554  2.0 and
2658
365
inventory turnover period   181.0019  181 days
2.016554
The shorter this interval, the better. A long period means it takes a long
time to convert inventory into sales.

Operating cycle: defined as operating cycle = ITD + RTD

This measures the time taken from when the firm commits to spend cash
to buy inventory to when the money is collected from the customer who
buys the finished product.

Cash cycle: defined as cash cycle = ITD + RTD - PTD

This measures the time taken from when the firm actually spends cash to
buy inventory to when the money is collected from the customer who
buys the finished product.